“...a highly readable and authoritative account of the problems we face from global warming to shrinking water resources, fisheries, forests, etc. The picture is very frightening. But the book also provides a way forward.” –Clare Short, British Member of Parliament

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April 07, 2010

Lowering Income Taxes While Raising Pollution Taxes Reaps Great Returns

Lester R. Brown

As economic decisionmakers—whether consumers, corporate planners, government policymakers, or investment bankers—we all depend on the market for guidance. In order for markets to work and economic actors to make sound decisions, the markets must give us good information, including the full cost of the products we buy.

Unfortunately, markets largely ignore the indirect costs of goods and services, thus grossly distorting the structure of the economy. The market price of burning coal, for example, includes only the direct costs, those of mining the coal and transporting it to the power plant. By neglecting the substantial indirect costs of burning coal—the costs of air pollution, acid rain, devastated ecosystems, and climate change—the market is giving us bad information. As a result of this and other distortions, we are making bad decisions.

The most effective way to correct this massive market failure is to restructure taxes—lowering taxes on income while raising those on environmentally destructive activities. Widely endorsed by economists, tax shifting helps make sure the price of products reflects their full costs to society.

The first step in creating an honest market is to calculate these indirect costs. Perhaps the best model for this is a U.S. government study on smoking from the Centers for Disease Control and Prevention (CDC). In 2006 the CDC calculated the cost to society of smoking cigarettes—including both the cost of treating smoking-related illnesses and the lost worker productivity from these illnesses—at $10.47 per pack.

This calculation provides a framework for raising taxes on cigarettes. In New York City, smokers now pay $4.25 per pack in state and local cigarette taxes. Since a 10-percent price rise typically reduces smoking by 4 percent, the health benefits of tax increases are substantial.

The many indirect costs of using gasoline—including climate change, oil industry tax breaks and subsidies, oil supply protection, and treatment of auto exhaust-related respiratory illnesses—total around $12 per gallon ($3.17 per liter), based on a conservative estimate by the International Center for Technology Assessment. If this external or social cost were added to the roughly $3 per gallon average price of gasoline in the United States, a gallon would cost $15. These are real costs. Someone bears them. If not us, our children.

Gasoline’s indirect cost of $12 a gallon provides a reference point for raising taxes to where the price reflects the environmental truth. Gasoline taxes in Italy, France, Germany, and the United Kingdom—averaging more than $4 per gallon—are a good start. That the average U.S. gas tax is less than 50¢ per gallon helps explain why the United States uses more gasoline than the next 20 countries combined. The high gasoline taxes in Europe have contributed to an oil-efficient economy and to far greater investment in high-quality public transportation, making it less vulnerable to oil supply disruptions.

Phasing in an incremental gasoline tax rising by 40¢ per gallon per year for the next 10 years and offsetting it with a reduction in income taxes would raise the U.S. gas tax to the $4 per gallon tax prevailing today in Europe. This will still fall short of the $12 per gallon indirect costs, but combined with the rising price of producing gasoline, it should be enough to encourage motorists to use improved public transport and to buy plug-in hybrid and all-electric cars as they come to market.

If gasoline taxes in Europe, which were designed to generate revenue and to discourage excessive dependence on imported oil, were thought of as a carbon tax, the $4 per gallon would translate into a carbon tax of $1,650 per ton. This is a staggering number, one that goes far beyond any carbon emission tax or cap-and-trade carbon-price proposals to date. It suggests that the official discussions of carbon prices in the range of $15 to $50 a ton are clearly on the modest end of the possible range of prices.

Tax shifting is not new in Europe. A four-year plan adopted in Germany in 1999 systematically shifted taxes from labor to energy. By 2003, this plan had reduced annual carbon dioxide (CO2) emissions by 20 million tons and helped to create approximately 250,000 jobs. It also accelerated growth in the renewable energy sector.

Between 2001 and 2006, Sweden shifted an estimated $2 billion of taxes from income to environmentally destructive activities. Much of this shift of $500 or so per household was levied on road transport, including hikes in vehicle and fuel taxes. France, Italy, Spain, and the United Kingdom are among the countries also using this policy instrument. In Europe and the United States, polls indicate that at least 70 percent of voters support environmental tax shifting once it is explained to them.

Some 2,500 economists, including nine Nobel Prize winners in economics, have endorsed the concept of tax shifts. Harvard economics professor and former chairman of George W. Bush’s Council of Economic Advisors N. Gregory Mankiw wrote in Fortune magazine: “Cutting income taxes while increasing gasoline taxes would lead to more rapid economic growth, less traffic congestion, safer roads, and reduced risk of global warming—all without jeopardizing long-term fiscal solvency. This may be the closest thing to a free lunch that economics has to offer.”

Environmental taxes are now being used for several purposes. For example, a number of cities are now taxing cars that enter the city center. Some governments are simply imposing a tax on automobile ownership. In Denmark, the registration tax on the purchase of a new car exceeds the price of the car by 180 percent. A new car that sells for $20,000 costs the buyer $56,000. In Singapore, the tax on a $14,200 Ford Focus more than triples the price, pushing it to $45,500.

Cap-and-trade systems using tradable permits are sometimes an alternative to environmental tax restructuring. The principal difference is that with permits, governments set the allowed amount of an activity and let the market set the price of the permits as they are auctioned off or given away. With environmental taxes, in contrast, the environmentally destructive activity’s price is incorporated in the tax rate, and the market determines the amount of the activity that will occur at that price.

The use of cap-and-trade systems with marketable permits has been effective at the national level, ranging from restricting the catch in an Australian fishery to reducing sulfur emissions in the United States, but it also has serious limitations. Edwin Clark, former senior economist with the White House Council on Environmental Quality, observes that tradable permits “require establishing complex regulatory frameworks, defining the permits, establishing the rules for trades, and preventing people from acting without permits.” While economists largely prefer tax shifting for its efficiency, transparency, and predictable prices, both carbon taxes and cap-and-trade schemes are likely to result in a higher cost for burning carbon, thereby helping to correct the current market failure.

A market that is allowed to ignore the indirect costs in pricing goods and services is irrational, wasteful, and self-destructive. The key to building a global economy that can sustain economic progress is the creation of an honest market, one that tells the ecological truth. To create an honest market, we need to restructure the tax system by reducing taxes on work and raising those on carbon emissions and other environmentally destructive activities, thus incorporating indirect costs into the market price. If we can get the market to tell the truth, then we can avoid being blindsided by a faulty accounting system that leads to bankruptcy.